Subunit 5: Macroecon and Globalization

Question 1

What are the four phases of the business cycle?

Answer 1

The business cycle has four phases:
1. Peak - At or near full employment and max output
2. Trough - Lowest point of economic activity
3. Recession - Real GDP falls and unemployment rises
4. Recovery - Output and employment rise

Question 2

What are the three types of economic indicators?

Answer 2

1. Leading indicators
2. Lagging indicators
3. Coincident indicators

Question 3

What is the business cycle?

Answer 3

The overall trend of economic growth is periodically interrupted by instability. This creates a tendency towards instability within the context of overall growth.

Question 4

What can cause recessions or troughs?

Answer 4

1) When consumer confidence declines, consumers spend less. Unsold inventory increases, and businesses respond by reducing production and laying off workers.
2) A miscalculation in fiscal or monetary policy by the government may cause a recession or trough.
3) A major default can trigger a cascade of confidences, reducing lending and consumption.

Question 5

Define economic indicators.

Answer 5

Items used to forecast changes in economic activity. In the past, these variables have highly correlated with the change in GDP. However, these indicators are meaningless in isolation, so the index is composite and has predictive uses.

Question 6

What is a leading economic indicator? What are the leading indicators used by the Conference Board?

Answer 6

A forecast of future economic trends. A change in leading economic indicators suggested a future change in real GDP in the same direction.
The Conference Board uses:
1) The average workweek for production workers
2) New orders for consumer goods and materials
3) Stock prices
4) New orders for nondefense capital goods
5) Building permits for houses
6) The money supply
7) Index of consumer indications
8) The spread between ST and LT interest rates

Question 7

What leading indicators suggest a future change in real GDP in the opposite direction?

Answer 7

1) Increased initial claims for unemployment insurance (more people unemployed indicates slowing business activity)
2) Decreased vendor performance (vendors have slack time and carry high inventory levels)

Question 8

What is a lagging indicator? What are examples of lagging indicators?

Answer 8

These indicators change after the change in economic activity has occurred.
1) Average duration of unemployment
2) Commercial and industrial loans outstanding
3) Average prime rate charged by the banks
4) Change in the CPI for services

Question 9

What is a coincident indicator? What are examples?

Answer 9

These indicators change at the same time as the economic activity change.
1) Industrial production
2) Manufacturing and trade sales
3) Personal income less transfer payments

Question 10

How is the inflation rate calculated?

Answer 10

Inflation rate = (Current-year price index - Prior-year price index) / Prior-year price index

Question 11

How is the Consumer Price Index (CPI) calculated?

Answer 11

CPI = Cost of market basket in current year / Cost of market basket in base year * 100

Question 12

What are the two types of inflation?

Answer 12

1. Demand-pull inflation
   a. Caused by an increase in aggregate demand from equilibrium (excess of demand over supply)
2. Cost-push inflation
   a. Caused by a decrease in short-run aggregate supply from equilibrium

Question 13

Define inflation. Why does the definition not sufficiently explain the effects of inflation?

Answer 13

A sustained increase in the general level of prices. The reported inflation rate is an average of all price increases across the economy.
The value of any monetary unit is measured by what it can buy (goods or services), measured by purchasing power. Inflation decreases purchasing power.

Question 14

What is a price index?

Answer 14

The price index is a measure of a market basket of goods and services’ price in one year compared to the price in a base year. The index for the base year is always 100. Inflation is calculated using a price index.

Question 15

Define the consumer price index.

Answer 15

The most common price index for adjusting nominal GDP. It measures changes in the general price level by a pricing of items on a typical urban household shopping list.

Question 16

How do you use the CPI to compare monetary amounts in constant dollars?

Answer 16

The amounts must be deflated using the appropriate price index. The difference then must be divided by the prior period’s amount.
This year: Nominal $ Y2 / CPI Y2 = Constant $ Y2
Last year: Nominal $ Y1 / CPI Y1 = Constant $ Y1
Difference: Nominal $ Diff Constant $ Diff / Constant $ Y1 = Real $

Question 17

Define nominal income.

Answer 17

The money received by a consumer as wages, interest, rent, and profits.

Question 18

Define real income.

Answer 18

The purchasing power of the income received. It is nominal income adjusted for inflation. Purchasing power relates directly to the consumer’s standard of living.

Question 19

How does nominal income compare to real income?

Answer 19

Real income decreases when the rate of increase in nominal income is less than the inflation rate.
Real income ↓ when % ↑ in nominal income < inflation

Question 20

What are the macroeconomic effects of inflation?

Answer 20

1) Unexpected inflation can cause economic chaos
2) The efficiency of economic relationships relies on stable pricing

Question 21

In financial reporting, what does inflation principally affect?

Answer 21

Inventory, COGS, and equipment and depreciation

Question 22

How does inflation impact LIFO inventory systems? How does it impact FIFO?

Answer 22

In a period of rapidly rising prices, LIFO increases COGS and decreases OI, thereby decreasing income tax liability.
In FIFO, COGS consists of lower inventory costs, thereby increasing OI.

Question 23

How does inflation impact long-lived assets?

Answer 23

Long-lived assets are recorded at historical costs (depreciable base). During a period of rising prices, depreciation expense is lower at historical cost than if it were stated at replacement cost. Reported OI is higher in the current period, but replacing assets as they are retired costs more.

Question 24

Define deflation. What causes deflation, and what are the consequences?

Answer 24

Deflation is a sustained decrease in the general price level. It is caused by conditions that are the opposite of those causing demand-pull and cost-push inflation.
1) A decrease in demand without a decrease in supply shifts the aggregate demand curve left. Firms sell inventory despite losses. Prices and output fall.
2) An increase in output without an increase in demand shifts the aggregate supply curve right. Prices fall.

Question 25

How is the unemployment rate calculated?

Answer 25

Unemployment rate = (Number of unemployed / size of labor force) * 100

Question 26

What are the three types of unemployment?

Answer 26

1. Frictional unemployment
   a. Caused by normal workings of the labor market (normal unemployment exists at any given time in a dynamic economy)
2. Structural unemployment
   a. Caused by unmatched skills (needs) of the workforce; composition of the workforce does not match the need, often caused by changes in consumer demand or tech or geographic issues
3. Cyclical unemployment
   a. Caused by decrease in an economy’s output (e.g., recession); likely to occur during recessions and is sometimes called deficient-demand unemployment

Question 27

What is full employment?

Answer 27

An economy is considered to be at full employment when it is at the natural rate of unemployment.
Natural rate of unemployment = Frictional unemployment rate + Structural unemployment rate

Question 28

Who is included in the labor force?

Answer 28

The labor force includes all individuals except those who are: 1) under 16; 2) incarcerated or institutionalized; 3) homemakers, full-time students, and retirees; and 4) discouraged workers (unemployed and able to work but not actively seeking)
No distinction is made between FTE and PTE; they are “equally employed”

Question 29

Who is included in unemployed?

Answer 29

Those who are willing and able to work and are seeking employment.

Question 30

What can distort unemployment statistics?

Answer 30

1) Workers who falsely claim to be seeking work
2) Those unemployed in the underground economy (cash-only basis workers)

Question 31

What are the macroeconomic effects of unemployment?

Answer 31

1) The primary economic cost is lost value to the economy—goods not produced and services not provided by idle workers are never regained.
2) Social costs include loss of skills, personal and family stress, violence and other crime, and social upheaval.

Question 32

Describe the relationship between inflation and unemployment.

Answer 32

Inflation and unemployment are inversely related and can be described using the Phillips Curve. When unemployment is low, firms have to pay higher wages to attract workers, increasing labor and production costs. Thus, the lower (higher) the unemployment rate, the higher (lower) the inflation.
This relationship applies only in the short-term. In the long-term, inflationary policies do not decrease unemployment.

Question 33

What are fiscal policies?

Answer 33

Fiscal policies are the use of taxation and expenditures by the government to reach macroeconomic objectives.

Question 34

How is the multiplier effect of spending on the economy calculated?

Answer 34

Spending has a cumulative effect on the economy that is greater than the initial amount. The multiplier in the economy is calculated as follows:
Multiplier = 1 / (1 - Marginal propensity to consume)
EXAMPLE: If a recessionary gap of $400 million exists and the MPC is 0.6, the multiplier is 2.5 [1 ÷ (1 – 0.6)]. Therefore, the government needs to increase its expenditures by only $160 million ($400 million ÷ 2.5) to increase the total GDP by $400 million.

Question 35

Give examples of tools of fiscal policy used by the government to change the aggregate demand in the economy.

Answer 35

Expansionary and contractionary fiscal policies include
* Tax policy
* Transfer payments (welfare, food stamps, UC)
* Government spending (highway maintenance, military buildup)

Question 36

Define discretionary and nondiscretionary fiscal policies.

Answer 36

Discretionary: fiscal policy where government individuals can control spending (e.g., contracting for new weapons systems)
Nondiscretionary: fiscal policy enacted in law. Certain outlays like Social Security must occur regardless of their consequences or source of funding because Congress legally requires them. No individual bureaucrat or group can choose to withhold or increase these expenditures.

Question 37

Why does the government use fiscal policy?

Answer 37

1) a reduction in consumer expectations leads to a decrease in consumption
2) Recession and unemployment follow as a result of real GDP decreasing
3) to promote growth and reduce unemployment, the government may increase spending

Question 38

Define the multiplier effect and the marginal propensity to consume. How are they related?

Answer 38

Multiplier effect: occurs because each dollar spend by a consumer in the economy becomes another consumer’s income, and so forth. An increase in government spending increases real GDP.
Marginal propensity to consume (MPC): The increase in consumption for every additional dollar consumers receive in income. The remainder that was not spent is saved.
Spending has a cumulative effect on the economy, greater than the initial amount.

Question 39

What does Keynesian theory say about fiscal policy?

Answer 39

It calls for expansionary fiscal policy during recessions to stimulate aggregate demand and contractionary policy during expansion to prevent inflation and reduce aggregate demand.

Question 40

Under Keynesian theory, when and how should a government adopt expansionary policies?

Answer 40

Governments should enact expansionary policies if a recessionary gap exists.
1) Decrease taxes and increase transfer payments, giving consumers more disposable income.
2) Increase government spending, which increases demand for private sector goods and services.
3) The federal deficit increases under expansionary policies.

Question 41

Define an inflationary gap.

Answer 41

The amount by which the economy’s aggregate expenditure at the full-employment GDP exceeds those necessary to achieve full-employment GDP.

Question 42

Under Keynesian theory, when and how should a government adopt contractionary policies?

Answer 42

Governments should enact contractionary policies if inflationary gaps exist.
1) Increase taxes and decrease transfer payments, giving consumers less disposable income.
2) Decrease government spending, which reduces demand for private-sector goods and services.
3) The federal deficit decreases under contractionary policies.
Issues in fiscal policy

Question 43

How do nominal interest rates differ from real interest rates?

Answer 43

Nominal interest rate = Real interest rate + Inflation rate

Question 44

In the context of money supply, what are M1 and M2 composed of?

Answer 44

M1 includes only the most liquid forms of money while M2 includes M1 and less liquid forms of money.

Question 45

What is the velocity of money?

Answer 45

The velocity of money is the number of times each unit of currency is used to purchase a final product in a given period.
Velocity of money = Nominal GDP / Money supply

Question 46

How is the amount of money banks potentially can create for taking deposits calculated?

Answer 46

Potential money creation = Bank deposits × Monetary multiplier
Monetary multiplier = 1 / Required reserve ratio
The money supply decreases as required reserves are raised.

Question 47

What are the three uses of money? Describe each.

Answer 47

1) Medium of exchange: money facilitates the free exchange of goods and services by providing a common means of valuation. Without money, we would have to barter everything, creating extraordinary inefficiencies.
2) Unit of account: money provides a convenient basis for bookkeeping. Anything stated in terms of money compares easily.
3) Store of value: Bartering creates great inefficiencies because many valuable objects like food spoil, rendering them worthless. The value of a monetary unit is determined by how much goods and services it can buy, not by its inherent characteristics.

Question 48

Define interest. What are the two major determinants of a loan’s interest rate?

Answer 48

The amount charged by a lender to a borrower in excess of the sum borrowed.
1) Overall economic conditions as reflected in the prime rate, which is the rate to the most credit-worthy customers
2) The creditworthiness of the borrower

Question 49

Define nominal and real interest rates. How do they work together?

Answer 49

Nominal interest rate: the stated rate on a loan
Real interest rate: nominal rate – inflation rate expected over the life of the loan
The lender must charge this inflation premium to compensate for the purchasing power lost while the loan is at the borrower’s disposal.

Question 50

What do misunderstandings between the nominal and real interest rates cause?

Answer 50

Misunderstandings over the difference between these rates can lead to economic distortions.
For instance, a loan bearing 10% interest may seem excessive to a borrower, but if inflation is 8%, the borrower is paying a real rate of only 2%.

Question 51

What does the M1 money supply illustrate?

Answer 51

Paper money and coins make up less than half the total money supply. The money in the economy greatly exceeds the currency in circulation because of banks’ creation of money.

Question 52

What is fractional reserve banking?

Answer 52

The practice of prohibiting banks from lending all the money they receive on deposit

Question 53

Define and describe the reserve ratio.

Answer 53

The required reserve ratio is the percentage of each dollar deposited that a bank must either 1) keep in its vault or 2) deposit with the Federal Reserve Bank in its district. Required reserves are the minimum legal amount that banks must hold.

Question 54

Define excess reserves.

Answer 54

The amount of customer deposits in excess of required reserves. Banks make loans from this amount.

Question 55

How does the Federal Deposit Insurance Corporation related to this process?

Answer 55

Fractional reserves cannot prevent a bank’s collapse if customers withdraw excessive amounts. The FDIC provides depositors with insurance and examines banks for safety.

Question 56

Give examples of tools of monetary policy used by central banks.

Answer 56

The tools of monetary policy are
* Open-market operations,
* The required reserve ratio, and
* The discount rate.

Question 57

Which type of open-market operations should central banks use to increase or decrease the money supply?

Answer 57

Question 58

What is the federal funds rate?

Answer 58

The federal funds rate is the rate banks charge each other for overnight loans.

Question 59

How do changes in money supply affect the federal funds rate?

Answer 59